Funds will find a chill Wind in the Willows: Lipper

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“Asset managers are emerging from their comfortable burrow to face a battery of lights.”

Sheila Nicoll, Director of Conduct Policy at Britain’s Financial Services Authority (FSA), had perhaps been reading Kenneth Grahame before her recent speech, and her words are likely to have sent a chilly wind through the willows of the UK funds industry.

The warning “poop poop” being sounded by the regulator has been getting louder and louder. Indeed the FSA may even be traveling faster than Labour Party leader Ed Miliband, who has recently suggested that he would impose a 1 percent cap on pension charges.

It was not so long ago that the FSA took a very different approach and removed its rules on excessive charges on the basis that “there may be no appropriate benchmarks” to determine this. They went so far as to say that “we do not act as a price regulator, and we do not consider it appropriate for us to take such a role.”

At the time, this move seemed all the more surprising as it was this very regulation that the FSA had referred to when trying to allay the Financial Services Consumer Panel’s fear that in allowing performance fees for open-ended funds, there was no requirement to cap such fees.

The more recent change in the FSA’s thinking was shown in its paper on product intervention, stating its intention to scrutinise both performance fees and the high charges for some index-tracking funds. The FSA did not shrink from suggesting that “it is possible to envisage the role of the regulator in imposing limits on price or excessive charges to remedy competition problems.”

FIDUCIARY DUTY

The loudest voice in the woodland is surely that of Martin Wheatley, the future head of the FSA’s successor, the FCA, who has questioned how an investor can tell whether charges are fair. He has promoted the idea of fund managers “adopting a fiduciary duty to their investors, something that would offer an extra level of commitment beyond simply the letter of our rules.”

While the Investment Management Association (IMA) is looking again at this issue, the funds association initially responded to Wheatley’s speech by questioning the “legal underpinning” of the term fiduciary duty. Having said this, the IMA has not stuck its head in the sand, publicly recognising such obligations earlier this year.

It also detailed the governance arrangements of funds back in 2005 in a paper which gave a succinct definition of ‘fiduciary duty’: “Both the Manager and the Depositary have an obligation to act at all times in the best interests of Investors, disregarding their own interests where they conflict with those of the investor.”

But the IMA made it clear that this duty stopped short of the depositary taking a view on “commercial matters” such as the level of the manager’s fee.

The Wild Wood that is the US funds industry casts a shadow over the discussion. First, the US regulator models itself as “The Investor’s Advocate” – an approach more akin to the new FCA – and second, it holds that fiduciary duty does relate to the oversight of funds’ fees.

Here, section 15c of the 1940 Investment Company Act comes to light, whereby fund boards (a majority of which are independent) must monitor their funds’ fee and expense levels in relation to the rest of the industry. This need not create a decisive argument that fund boards are a panacea, but it does demonstrate a different and viable approach to overseeing fees.

One way this scrutiny manifests itself is in passing on economies of scale achieved to investors, as discussed in a previous column. If the UK and European industries are to demonstrate that they are giving investors as fair a deal as possible, then this nettle needs to be grasped. Simply capping fee levels at a fixed percentage will not suffice.

WEASELS OR BADGERS?

If funds can justify the fees they charge by their performance – as many do – then some of the critical voices may be quieter, or find a less receptive audience. But demonstrating this over both the long term (as mutual funds are designed to do) and the shorter term (say up to 3 years, which has a more significant impact on fund sales) remains the challenge for asset managers.

Some consumers may well see fund managers as weasels, rather than an array of friendly moles, wise badgers or shrewd water rats. But such a perception crucially highlights the problem of exactly how consumers think of fund fees: some see them simply as the fuel for a lifestyle of fast cars and mansions out of step with the rest of society, while others will look at fees from an investor’s viewpoint, as a downward ‘drag’ on returns.

This second element, the actual cumulative impact of annual charges on average equity fund returns over ten years, is illustrated in the following chart:

Despite this, retail investors have traditionally given more weight to funds’ past performance then their ability to keep costs low. This leads on to a question that the FSA’s Wheatley posed: “we might ask ourselves whether it is a problem that the industry appears to compete predominantly on the aspirational aspect of its service… when it is the one thing that cannot be compared and measured by potential investors.”

The counter-argument to this question must be that as long as investors, or their advisers, place a greater emphasis on a manager’s track record than on charges, then it remains a very tough proposition to grow a retail business based on what investor behaviour should be (depending on your perspective), rather than one based on what it is. Perhaps this is the equivalent of traveling quietly in a horse-drawn caravan while others race by in motor cars.

The impact of such attitudes is that the average annual charges at mutual funds in the UK have slowly been rising. Part of the reason for this may be laid at the feet of independent financial advisers (IFAs) and platforms, in the form of trail commission, and it is this that will be radically changed with the Retail Distribution Review (RDR) next year as customers will have to agree separately the fees they pay for advice.

A chart showing the historical trend in annual fund charges can be seen below:

So are managers really emerging from their burrows? Surely all fund companies have been buffeted by the financial crisis and witnessed the march towards greater regulation, not only the RDR in the UK, but also laws from across the Channel and the Atlantic.

As for investors, there is greater cost disclosure underway, although this need not mean they will pay less overall. Regulatory changes have already resulted in there being far more choice for cost-sensitive investors, who can certainly pay much lower fees unless they believe a manager is really worth it. Or as Kenneth Grahame put it, “good, bad, and indifferent – I name no names – it takes all sorts to make a world.”
(Editing by Joel Dimmock) (joel.dimmock@thomsonreuters.com; Twitter: @reutersJoelD; +44 20 7542 3505)

Author Profile

I am currently Head of UKI & Cross-border Research at Lipper, a Thomson Reuters company. I have spent the past twelve years researching the European mutual funds industry, having originally joined a specialist in fund fees, Fitzrovia International, in 1999. Although fees remain a particular interest, my research at Lipper also covers fund flows, performance and related industry dynamics.